Interest rate uncertainty
Emerging economies’ central banks that are tasked with multiple mandates and are concerned with the impact of swings in capital flows might use interest rate uncertainty as an unconventional policy tool to dampen inefficient capital inflows. This is the thesis that Ghironi et al. pursue in this paper. They develop a two-region New Keynesian model (the emerging market economy [EME]) and the rest of the world [RoW]) that separates international flows in a) short-term bonds and b) international investment in physical capital or FDI. They show that using interest rate uncertainty is an effective policy tool in discouraging inefficient capital inflows and shifting those towards FDI for two reasons:
- First, response to increased uncertainty in the EME’s policy rate, the EME’s bond returns do not compensate for the additional risk created by the central bank, and RoW investors shift away from holding EME debt;
- Second, under imperfect exchange-rate pass-through, exporting firms respond to rising uncertainty by decreasing their prices and by increasing their demand for inward FDI to expand production.
Finally, they compare the interest rate uncertainty policy with capital control uncertainty and find that EME households prefer to live under the interest rate uncertainty regime, instead of the capital control uncertainty regime.
Interest Rate Uncertainty as a Policy Tool
Authors: Fabio Ghironi, Galip Kemal Ozhan
From: University of Washington, Bank of Canada
